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Before Derrick Sung took over coverage of the medical-device industry for Bernstein Research three years ago, he worked for more than a decade in the business. The Stanford-trained engineer designed heart catheters at the Guidant division of Eli Lilly that's now part of Abbott Labs. After receiving a Ph.D. in bioengineering from the University of California at San Diego, he gave advice at Boston Consulting, then ran business development for a division of Boston Scientific. His sector's been battered, but he sees some reasons for hope.

Barron's:What's ahead for the medical-device makers?

Sung: There are two headwinds that have been pressuring these stocks recently. The first is the potential for cuts to government health-care spending. The second is simply the macro economy, and how that is impacting procedure volume.

[In the economy, we're] seeing a cyclical pullback in the U.S. in the more elective procedures, such as hip and knee replacements. Patients are deferring these procedures, as they feel less comfortable about their job security and their personal savings. In Europe, austerity measures are also pressuring utilization and pricing of medical devices.

"Health care accounts for nearly a quarter of the…budget. So it is inevitable that we'll be seeing cuts to both Medicare and Medicaid. And that's likely to trickle down to the medical-device industry." —Derrick Sung
Martin Klimek for Barron's

[The governmental headwind is playing out in the] deficit-reduction discussions happening in D.C. right now. Health care accounts for nearly a quarter of the U.S. federal budget. So it is inevitable that we'll be seeing cuts to both Medicare and Medicaid. And that's likely to trickle down to the medical device industry.

The procedures that the large-cap medical device companies focus on—pacemakers, ICDs [implantable cardioverter-defibrillators], replacement hips and knees—they're very expensive. For example, $10 billion annually is spent by hospitals on knee replacements, and $10 billion on coronary stents. It really puts these procedures in the cross hairs.

What you expect from the government?

We've tried to approach this top-down, as we think legislators might do. The [bipartisan] Super Committee is trying to get to $1.5 trillion in budget cuts over the next 10 years. With health care at 25% of the federal budget, that translates to a range around $375 billion in health-care cuts. Medical-device spending is about 6% of health-care expenditures, so 6% of $375 billion leads to approximately $20 billion that could be viewed as the medical-device industry's fair share of deficit reduction.

That calculation gives us a proxy for what the earnings impact might be for any additional cuts in Washington. For every extra $20 billion that the device industry might need to pony up, it could have approximately a 5% earnings impact.

Has the use of these devices also slowed because of medical findings, as opposed to financial pressures?

Comparative-effectiveness research is a risk to utilization, going forward. Back in January, a study published in the Journal of the American Medical Association, or JAMA, suggested that a large portion of ICDs, about 20%, were being implanted out of guidelines—that is, in patients that did not need them. Simultaneously, we've seen the Justice Department investigating hospitals. As a result, we've seen a significant pullback in the U.S. ICD market. It went from being sort of flat last year, to being down 12% year-over-year, in the quarter ended June 2011. A survey we just conducted indicates that the market has declined further in the third quarter.

Haven't there also been studies of drug-eluting stents?

Recently there was a JAMA study looking at unnecessary use of stent procedures, and we've seen congressional investigations around individual physicians alleged to have overutilized drug-eluting stents.

We've seen a similar evidence-based pushback in spine procedures, as well. But this came from the private payer side—the insurers. There is a lack of evidence for a certain category of spinal fusions, namely for lower-back pain without evidence of spinal instability. Those had made up about 20% of all spinal-fusion procedures done in the U.S.

Is there any positive offset from rising health-care consumption in emerging markets?

Today, almost 90% of implantable device sales come from the U.S., Western Europe and Japan. There is a large population in India and in China, and when you look at per-capita utilization of these devices [in those countries], it is much, much lower.

But I don't see emerging markets as a near-term panacea for growth. Implantable devices take a significant amount of physician training and support infrastructure. These are expensive, sophisticated items.

Are there novel medical technologies that could create new markets, like the drug-eluting stents did a decade ago?

Innovation is not dead within the medical-device industry. I would highlight a couple of new technologies. Trans-catheter valves are a big innovation. This is implanting a heart valve without having to do open-heart surgery. The valve is threaded through the veins of the patient.

Edwards is the primary company, and a market leader. They are going to be first to market in the U.S., with their Sapiens valve. Medtronic will likely be second with their competing Core valve device. There is clearly an unmet need. It is probably going to be a billion dollar-plus market.

Left-ventricular-assist devices are another area that is very interesting. It is basically an evolution of the artificial heart, so small that it is a little implantable pump that helps failing hearts. It can be used two ways. One is to bridge patients who are candidates for heart transplants. The second, much larger indication is "destination therapy," that is, long-term use in heart-failure patients who may not be transplant candidates. The two companies involved in this space are
HeartWare HTWR 2.231488786205342%Heartware International Inc.U.S.: NasdaqUSD90.71
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[HTWR] and
Thoratec
[THOR].

Might they be of interest to larger acquirers?

Edwards, Heartware and Thoratec…yes. I don't cover them so I can't speak to their valuations, and it is hard for me to give a recommendation.

Yeah, over the long term you are going to see the benefits of scale and diversity of product offering—especially as we see increasing pressure coming from the hospitals as they try to pass on their reimbursement cuts. Scale can give the companies more bargaining power, making them that must-have vendor.

The second reason that I think we will see more consolidation is because it is an opportunity for the device companies to achieve cost synergies. Companies see their pricing and margins getting squeezed. They are going to cut costs. And one of the ways to cut costs is to have a merger and eliminate duplicate sales forces.

Who do you like?

J&J is a perfect example. They get it. They see what is coming and take an active view on portfolio management to succeed in this environment. The recently announced Synthes acquisition gives them the breadth of product and scale to be an ortho superpower. They become No. 1 or No. 2 in hips, knees, spine and trauma. The Synthes trauma products are screws, nails and plates to internally fix broken bones.

Synthes also gives them a very interesting entree into emerging markets. In developing countries, ortho surgery tends to be trauma surgery. Synthes' foothold in emerging markets allows J&J to develop a physician base to whom they can offer more sophisticated ortho products like hips and knees, as those economies develop.

So J&J is my top pick right now in the sector. Even in the next 12 to 24 months, they will see a re-acceleration in their three core businesses: medical tech, consumer and pharmaceutical. The Synthes acquisition and their exit from the drug-eluting stent business should take med tech from 2% growth today, to 5%-to-6%.

Sung's Haves

9/22/11

Company

Ticker

Price

Johnson & Johnson

JNJ

$61.92

Medtronic

MDT

32.91

Zimmer Holdings

ZMH

53.46

... And Holds

Abbott Laboratories

ABT

$50.69

Boston Scientific

BSX

5.62

St. Jude Medical

STJ

38.48

Sources: Bloomberg; Bernstein Research

On the pharma side, the company is getting over their "patent cliff," and they have a number of blockbuster products that have just recently launched. They just got approval in Europe for Incivo to treat the hepatitis C virus. They also launched Zytiga for prostate cancer in the U.S. and Europe. Both of those are multibillion-dollar products. They've also got another new product called Stelara, an interleukin-12 and -23 inhibitor used to treat psoriasis. That's on track to become a billion-dollar product by 2012.

The last piece of their business is their consumer operation, where they've been plagued by high-profile recalls in their McNeil consumer division—Tylenol, most notably. Next year they are introducing those suspended products back into the market. That should drive a nice acceleration in growth there.

J&J is a great way to ride out the current market volatility. We've shown that over the past 10 years, J&J has tended to outperform both the market and other health-care-products stocks in a bear market. It has a 3½% dividend yield. You put all those together, and that's what makes J&J our top pick today.

Your current target price for J&J is 75 bucks, and you figure that they can earn about five bucks this year and almost $5.40 next year?

Exactly.

Over at Medtronic, they have a new CEO.

Medtronic is another stock that I like. The story here is all about new-product cycle, new management and compelling valuation.

Medtronic is going through a new-product cycle. For a period of about two years, because of a series of Food and Drug Administration warning letters, they weren't able to get any new products out. They lost share in pacemakers and ICDs. Well, they've gotten the warning letters lifted and have been able to get out meaningful new products. They recently launched the first MRI-safe pacemaker in the U.S. market, which they call Revo MRI. They've also launched a next-generation ICD, called Protecta, that is designed to reduce unwanted shocks. Those products are currently driving revenue and share gains. The company has also launched a new spinal-fixation platform and will be launching a new drug-eluting stent.

So they have this series of new products, and we see that transforming them from a share loser to a share gainer. In the last quarter, for the first time in two years, they stabilized their share in ICDs and they actually gained share in pacemakers.

And then they've gotten new management: a new CEO who came in from GE, Omar Ishrak. We expect him to increase Medtronic's focus on operational efficiency and bring discipline to capital-allocation decisions.

The last piece is their compelling valuation, relative to their sector. Medtronic is trading at nine times 2012 earnings—with a free-cash-flow yield of 11%—while the large-cap med-tech sector is trading at closer to 11 times. I would expect to see that valuation gap narrow over the coming 12 months.

The stock trades around 32. What is your target price?

We have a $43 price target, driven by a multiple expansion, and we expect them to be able to do $3.44 in their fiscal year ending April 2012, and $3.76 in fiscal 2013.

You think Abbott is closer to fully valued?

Yeah, Abbott is still very much tied to the prospects for Humira, which is a $7 billion product for them. They are facing potential competition from an oral inflammation-inhibitor called Tofacitinib, for which
PfizerPFE 0.9235936188077246%Pfizer Inc.U.S.: NYSEUSD36.06
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[PFE] has just completed Phase III clinical trials. Between now and the launch of Pfizer's product in 2013 will be a tough overhang for Abbott. We think that nearly 40% of Abbott's profits come from Humira.

We have talked about slowing growth in this sector, but demand for medical devices won't go away. In fact, it will increase with the aging of our population. Unlike pharmaceutical companies, device makers can continue to sell the same products for the foreseeable future—generating reliable streams of free cash flow.

Who owns these stocks nowadays?

This sector has traditionally attracted growth investors. Now, with growth clearly slowed, we are starting to get interest from value investors. The challenge is that many of the management teams still think of their companies as growth companies, and that scares many value investors. Will the companies squander cash flow on bad deals, chasing growth? The companies that return cash to shareholders and cut costs—those are going to be successful over the long run.

Like Zimmer?

Zimmer returns a substantial amount to their stockholders in the form of share buybacks. They have been very consistent, even going to the debt markets to return that capital to shareholders.

The other thing that is compelling about Zimmer is a very low valuation. It is trading at 10 times. It has a high free-cash-flow yield of 10%. At some point we are going to see a cyclical recovery in the elective-orthopedic market. When that recovery does come, Zimmer will benefit.

They are gaining share in hip replacements with a new product cycle. And they are launching an interesting product late this year or early next year, called Gel-One. It is injected into the knee and lubricates the joint for patients who have osteoarthritis. That's nearly an $800 million market in the U.S. It will be only the second single-injection product to market.